In the last one year, debt funds have been able to generate double-digit returns on the back of the Reserve Bank of India (RBI) reducing the interest rates. This has helped beat post-tax bank fixed deposit returns by a good margin (in excess of 4-5%). For example, on a R10-lakh investment, investing for one year at an additional 1% return amounts to an additional return of R10,000. So, an additional 5% return amounts to R50,000.

Debt funds comes in various forms — liquid fund, ultra short-term, medium-term, dynamic bond , long-term corporate bond funds and gilt funds. With so many categories, it’s important that you know what type of debt investment product you are investing in. Debt products carry interest rate and credit risks. In a rising interest rate market, if you invest in a longer duration debt product, your returns will be subdued and, possibly, below FD returns. Similarly, in a falling interest rate regime, if you invest in shorter duration debt products, you will bear the brunt.

Debt Funds — G-Secs/Gilts

In a falling interest rate regime, government securities or gilts, as they are more commonly known, come into play. Government securities include Central government dated securities, state government securities and treasury bills. To enable retail investors to invest in gilts, MFs offer this product through gilt funds, as the space is typically dominated by institutional investors.

In the current economic environment, interest rates are expected to come down. Bond prices and interest rates are inversely related. Falling interest rates have led to an appreciation in bond prices. The fund flow into gilt funds in the last two quarters is also an indication about the investors’ appetite for them. During 2008-09, the one-year return form gilt funds was anywhere between 22% and 32%. This phenomenon was never experienced in debt mutual funds. Again, as gilt fund were a relatively new option, there were not many retail investors who could be a party to the gains. But today, with investors having increasing access to information, gilt finds are gaining in popularity.

Outlook

To contain inflation and enhance growth, RBI and the government are taking a host of policy initiatives. The gradual reduction in interest rates has ensured that debt MFs will generate healthy returns — similar to that in 2012, if not better. The government borrowing programme, which has an impact on gilt funds’ interest rate, will be another important factor.

However, investing in gilt funds is not entirely risk-free. Though it does not carry a credit risk — G-Secs have a sovereign guarantee — the interest rate risk is there. When interest rates rise, G-Secs fall, which, in turn, impacts return. Again, long-term G-Secs can be illiquid. If there is a redemption pressure, the funds will have to be liquidated at a loss.

Having said that, investors with a horizon of over a year could allocate funds based on the risk and time horizon in this product. Will returns generated in 2008-09 be revisited in gilt funds? It’s a conjecture. But what can be expected on a prudent note is inflation beating returns.

Allocation to gilt funds, based on the time horizon, in an investor’s portfolio should be actively considered. A falling interest rate scenario gives confidence of inflation beating returns.